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As a freelancer, you’ve probably heard the words LLC and S Corp floating around. And you probably need to decide which one to form. But who wants to spend their time thinking about which business entity to choose? BO-RING.
You wish that the decision would just go away. But, when it comes to running a business-of-one, tax and legal matters are inevitable.
That means it’s up to you to take care of the legal side of running your business. And that starts with knowing the differences between an LLC and S Corp and how each one will impact your business.
LLC vs. S Corp: The basics
As a freelancer, the two entities you’ve probably heard the most about are single-member LLCs and S Corps. Before we talk about the difference, we got to get one technical thing straight.
Technically, an S Corp isn’t a legal entity but a tax election.
Wait- what? I thought this article was about legal entities!
It’s confusing but bear with us.
The IRS assigns every business structure a default tax treatment…which is just a fancy way of saying that the IRS decides how each business structure is taxed.
Single-member LLCs are automatically taxed like sole proprietors unless they ask otherwise. That’s where the S Corp election comes in.
You can ask the IRS to tax your single-member LLC as an S Corp, which means that the IRS won’t tax you under the rules of a sole proprietorship, they’ll tax you under the rules of an S Corp, (which we’ll talk about later).
To keep things simple (and your brain from exploding) in this article, we will be referring to:
- Single-member LLC as an LLC
- Single-member LLC electing to be taxed as an S Corp as an S Corp
Now that we’ve gotten that out of the way let’s talk all about LLCs vs. S Corps.
Taxes
The biggest difference between an LLC and S Corp is how you’re taxed.
An LLC and S Corp are both pass-through entities. That means that all the profits from the business are passed on to the owner’s tax return. Unlike a C Corp, which has to pay corporate taxes, your business doesn’t pay any taxes, you do.
How an LLC is taxed
The IRS automatically taxes an LLC like a sole proprietorship. Under this tax treatment, you’ll pay two types of taxes:
- Self-employment tax – 15.3% of 92.35% of your profit. Self-employment tax goes towards your Social Security and Medicare.
- Income tax – Varies based on your tax bracket.
You probably know that self-employment tax is a killer, and it’s why freelancers feel the burn at tax time. It’s also why taxes feel so much higher when you’re a freelancer than an employee.
When you’re an employee, your employer pays for half of this 15.3% through payroll taxes and deducts the half from your paycheck.
When you’re a freelancer, you pay for all of it yourself- and no one takes it out of your paycheck for you. That’s like real adulting.
How an S Corp is taxed
When it comes to S Corps, there’s one major tax difference that can save you some serious money: S Corp owners don’t pay self-employment tax on the business’s profits. They only pay income tax on the profits.
ERMGGGGGGG! That’s the best thing ever!
It is, but there’s a catch. S Corp owners are required to pay themselves a ‘reasonable compensation’ via payroll. And your employee wages are subject to FICA payroll taxes.
FICA payroll tax is 15.3% of your employee wages. Yes, that’s the same amount as self-employment tax. But, the difference is that your business pays half of that (7.65%) through employer payroll taxes and you pay the other half (7.65%), which is deducted from your paycheck.
Basically, you pay the equivalent of self-employment tax, but only on your employee earnings.
In addition to FICA payroll taxes, you’ll also pay FUTA payroll taxes, which is 0.62% of the first $7,000 of each employee’s wages.
There are a few other things to know about S Corp taxation:
- Your payroll taxes and the salary you pay yourself are a tax write off, which lowers your taxable profits.
- There’s no federal guideline for reasonable compensation, but a good rule of thumb is that your salary should be 40-60% of your pre-payroll net profit.
- You’ll also have federal and state income tax withheld from your paycheck.
- Your income tax will include your employee wages and the profits from your S Corp.
Tax savings: LLC vs. S Corp
Let’s do an example to compare the taxes a freelancer would pay as an LLC and S Corp. First, let’s look at how an S Corp changes your business’s profit.
Now let’s look at self-employment and payroll taxes.
That’s a $6,046 difference! Keep in mind that these tax numbers don’t include your income taxes, which will vary based on your tax situation.
If you want a personalized comparison, check out Collective’s tax savings calculator.
Additional costs
If you’ve already started to swipe right for an S Corp, hold up. Because even though an S Corp’s Tinder profile looks great, there’s some stuff you should know before committing.
S Corps cost more money to run than an LLC. If an LLC orders a salad on your first date, an S Corp is going to order the lobster, dessert, and that third glass of wine. So your wallet better be ready.
These are some of the additional costs associated with an S Corp:
Payroll service fees
You 100% don’t want to do manual payroll yourself. Manual payroll involves a lot of percentages, tax calculations, quarterly and annual forms, and ongoing payments to the IRS. And guess what happens if you calculate your payment wrong or miss a deadline.
The IRS gives you a puppy?
WRONG! The IRS gives you a big ol’ penalty and you pay interest on any underpayments that you made.
Trust me. It’s way more work than you want to deal with. Instead, you can use a payroll service that runs payroll for you and takes care of all your tax payments and paperwork. Our favorite payroll service is Gusto, which is perfect for S Corp owners.
But like most magical things that do all the work for you, Gusto isn’t free. For an S Corp owner, Gusto will cost you $45 month to run payroll.
Bookkeeping costs
As an S Corp, the days of doing your bookkeeping via a shoebox full of receipts are over. With great tax savings comes great accounting responsibilities, and S Corps are under more scrutiny by the IRS.
Translation? It’s time to get serious about your bookkeeping and use a legit accounting program, like QuickBooks Online. The most basic QuickBooks Online subscription will cost you $20 per month.
Tax preparation fees
When you’re an LLC, you report your business’s income and expenses on your personal tax return and you only file one tax return.
As an S Corp, you’ll file your personal tax return plus a corporate return called the 1120-S, U.S. Income Tax Return for an S Corporation. Filing this extra return will set you back several hundred dollars.
Annual state registration fees
Depending on where you live, you might have to pay a yearly registration fee for your LLC and S Corp. Fees range from $20- $800 per year.
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Cash Flow
S Corps require steady cash flow.
Cash flow is the money that comes in and goes out of your business in a given period. While cash flow includes your income and expenses, it also includes things like transferring money to your personal account, debt payments, and savings.
Sometimes, businesses are profitable but don’t have enough cash flow to sustain their operations because too much money is going out to cover debt, taxes, or owner pay.
With an S Corp, every time you run payroll, you pay a portion of your taxes in real time, both as the employer and employee. This means you need to have the money available for your salary and payroll taxes every month.
But wouldn’t I be paying these taxes at the end of the year, anyway?
You would! But if you have trouble covering your taxes at the end of the year or are underwater because of debt payments, really be honest with yourself: Can you keep enough money in the bank to run payroll every month?
If not, then an S Corp might not be right for you.
Liability protection
The good news is when it comes to liability protection S Corps and LLCs offer the same level of limited liability protection to their owners. That’s because an S Corp is an LLC taxed under the rules of an S Corp.
Limited liability means that if your business is sued or can’t pay its debt, creditors and claimants can’t go after your personal assets, like your house or car. While there are some exceptions to this rule, generally, this is the case.
Which one is best for you?
The truth is, the less you earn, the less beneficial an S Corp will be for your taxes. Even if you have some tax savings, the additional costs might eat up all your tax savings. Then you just have more work to do with no payoff.
Here’s a comparison chart of how much you can save with an S Corp, based on your income:
*Social security and Medicare tax only
We know that reading about a bunch of legal and tax blah blah blah can start to make your eyes glaze over. So here’s a helpful chart to help you understand the differences between an S Corp and LLC.
*While not required for LLCs, bookkeeping software is recommended for LLCs.
Now that you have all the deets about LLCs and S Corps, you can make an intentional decision about which entity to form and free up your mind to focus on the fun parts of running your business.
Andi Smiles, small business financial consultant and coach, teaches rad business owners to take control of their finances so they can step into their personal power.
She’s helped hundreds of self-employed folx organize and understand their business finances, while also uncovering their emotional relationship with money. Andi’s core belief is that when business owners are engaged with their finances, their personal awareness around money deepens, creating more sustainable and authentic businesses. She loves helping business owners connect with and feel good about their finances- no matter how many dollars are in their bank account.
